Value, Risks And Dividends

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

There's an interesting gap between what is happening in the share market and what securities analysts and financial strategists argue should be happening. As the ASX200 index in Australia continues its struggle to remain inside the 4500-5000 trading range and outside the 4600-4200 range, sector analysts and equity strategists have been taking another detailed look at their assumptions, models, forecasts and preferences – they see no reason to start making any profound changes.

This implies earnings forecasts for fiscal 2011 are likely to come in more or less as expected, which is a positive as the underlying trend in market expectations has been negative since May last year and only recently have we noticed a stabilisation, with the pendulum swinging towards downgrades for energy stocks and miners instead of industrial companies which have been carrying a very heavy cross over the past 14 months.

On my own calculations, which are corrected for large outliers either way, consensus forecasts for ASX200 companies remain for approximately 7% growth in earnings per share in FY11, to be followed up by no less than 21% growth in FY12. We're in the early phase of confession season but no wave of profit downgrades has been seen, not here and nor overseas. Sceptics will point out it's not so much FY11, but more so FY12 investors should worry about. I agree. 21% growth seems like a whole lot during times of ongoing uncertainties. Remember, the past two years have only provided low single digit EPS growth on average for Australian companies.

So while 21% seems too high and cuts to forecasts for FY12 seem one of few certainties currently hanging over the Australian share market, it has to be noted analysts and strategists remain of the view there's value in today's share market. The latest to reiterate such view are quantitative analysts at Goldman Sachs who, after another detailed study, concluded on Monday investors are seemingly unwilling to pay up for companies that are anticipated to record strong growth in the three years ahead. This, say these analysts, while it doesn't appear present expectations will prove too ambitious.

My personal view in this regard is that 21% growth leaves a lot of room to cut and then leave plenty of room for further share prices rises. Also, investors shouldn't forget there are quite a number of companies which have performed poorly over the years ahead. As such the bar is now very low for companies such as Stockland ((SGP)), APN News & Media ((APN)), Hills Holdings ((HIL)) and Telecom New Zealand ((TEL)).

One of the factors in the Goldman analysts' research is that projected profit margins for selected growth companies will in most cases still remain well below the peak levels of 2007. More importantly, however, is the fact that today's valuations for these companies remain well below historical averages.

Combining the three year growth outlook with below historical Price-Earnings (PE) multiples plus the fact that projected profit margins will still be below past peak levels by 2013 suggests to Goldman Sachs there's no shortage in opportunities out there, it's just that investors don't want to see it. These companies include the likes of Qantas ((QAN)), Virgin Blue ((VBA)), Nufarm ((NUF)), Graincorp ((GNC)) and News Corp (NWS)).

To be honest, I personally think the likes of Nufarm come with too many risks attached, and the same goes for Qantas and Graincorp, stocks that are too volatile to be considered in a conservative medium to long term investment portfolio, unless to add some potential oomph with lots of risk. (I am never in favour of owning shares in News Corp).

Goldman Sachs' quantitative team has also identified names such as Bradken ((BKN)), Amcor ((AMC)), Ramsay Healthcare ((RHC)), Lend Lease ((LLC)), JB Hi-Fi ((JBH)), Boral ((BLD)), Wesfarmers ((WES)) Crown ((CWN)), ResMed ((RMD)) and Seek ((SEK)); companies that arguably should be on investors' radar.

And then there are the "dogs" of today that should look a lot better over the next three years, stocks such as Insurance Australia Group ((IAG)), Aristocrat Leisure ((ALL)), Henderson Group ((HGG)), Suncorp-Metway ((SUN)), Bank of Queensland ((BOQ)) and Macquarie Group ((MQG)).

All three groups of companies have one key denominator in common. Their EPS growth should average at least 15% over the next three years (FY11-13) while present valuations do not account for this. Additional research by Goldman Sachs suggests forecasts do not seem overly ambitious.

The problem investors are facing with following up on valuation/forecasts convictions such as these, is there's no guarantee that today's cheap looking share prices won't be heading for even lower prices tomorrow, next week or even next month. Such is life in the post-GFC world when structural macroeconomic matters at times ruthlessly push any other considerations to the sidelines.

I was reminded about this myself recently by a subscriber in Perth who has been keeping a track record about the market views I have been expressing, as well as the individual company names I have been mentioning, both in my writings as during my TV appearances. Wrote this subscriber: Rudi, you called the market top in April and that really was spot on. But all companies you have mentioned since are today lower in share price.

Ooops?

Not really. The reason why I mentioned the analysis from the quant team at Goldman Sachs earlier is because there are some blatant similarities with what we do at FNArena and with what I do personally in my weekly market analyses and commentaries. Ours is not the task to provide Buy, Hold and Sell recommendations but to educate subscribers and readers and to provide tools and insights that assist them when making investment decisions (preferably in communication with a licensed advisor). The better informed investors are, and the more knowledgeable, the better they are able to make use of my analyses and the tools at FNArena.

As such I find myself today in the same position as those quant analysts at Goldman Sachs (who are different from the stock analysts and the stockbrokers who work at the same firm). I have been suggesting on an investment horizon of at least three years, that industrial stocks offer better opportunities than miners and energy companies, yet none of my analyses have prevented share prices for the likes of Ardent Leisure ((AAD)), National Australia Bank ((NAB)), Fleetwood ((FWD)), McMillan Shakespeare ((MMS)) or Transfield Services ((TSE)) -all companies that have been mentioned on more than one occasion over the months past- to fall in price.

Luckily, I had anticipated this dilemma and as such, even before April, I clearly stated my personal preference was for solid industrial stocks that pay sustainable dividends, to be owned for at least three years. Past analysis has taught me nothing beats accumulating growing dividends over time. On a shorter-term basis, I lean towards the views as expressed by market strategists at Macquarie which, in essence, are centred around a repeat of the 1964-1981 experience. A chart for this period featured prominently during my very first presentation in front of a live audience of investors in September 2008 (AIA in Chatswood). I have seen no reason to date to change this view, neither has Macquarie.

The period 1964-1981 was dominated by short cycles for both economies and for equities and at the end of the period equities were essentially at the same level as they were in the sixties. Another reason to highlight the value of sustainable, growing dividends.

The major benefit with dividends, however, stems from the fact that more often than not perfect timing is something only Harry Hindsight can maintain. Investors who bought the likes of Ardent Leisure and Fleetwood at share price levels higher than today's prices can at least relax, knowing there are regular payments coming their way that are well above the market average. Compare this with those who thought back in 2006 that Woodside Petroleum ((WPL)) was one share investors simply had to own. Fast forward five years (and still counting) and the share price is still at $40. Dividend payments are not exactly something to look forward to when owning Woodside shares.

Having said so, I also think active investors should always keep an eye open for shorter term opportunities. Woodside shares surged to nearly $70 and then fell to $30 at some point over the past five years. More recently they surged above $50 before falling back below $40. These are potential returns the dividend stocks I mentioned earlier are unlikely to provide.

For investors, the task at hand is to know what you want, but also to know your limitations. John Bogle, founder of Vanguard, once upon a time created the first index funds on the belief that active funds managers would not be able to outperform consistently and over a longer term horizon – probably because Harry Hindsight is a very wise man, but always in hindsight.

(This story was originally written on Monday 11 July 2011. It was sent out in the form of an email on that same day to paying subscribers).

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